Friday, March 26, 2010

Did ObamaCare Spook the Bond Market?

While financial pundits have been watching stocks rise, bonds have fallen sharply with yields spiking up. We have just had three bad Treasury auctions in a row - demand was weak for 2-yr notes on Tues, 5-yrs on Wed and 7-yrs on Thurs. The signature 10-yr is rising towards 4% (see chart). As the Fed is now ending QE for mortgages, rates for a 30-yr mortgage have risen above 5%.

The most inexplicable moment this week came when interest-rate swaps priced corporates BELOW Treasuries, a first. Treasuries are supposed to be the safest bet around, and should price below corporates. No one is sure if this is a blip or a trend. It may be just a blip due to a lot of corporates being issued right now. (Instead of bank borrowing, US companies are issuing debt - which means a lot of moaning of lack of bank borrowing is missing this alternative path to credit). Morgan Stanley takes it as a signal that Treasury rates are about to spike up to their target of 5.5% in the 10-yr. ZH has a long treatment, worth reading.

Technically, Treasuries are breaking out of a channel/triangle since December, and fairly sharply. How far they will run is unclear. Triangles often end with thrusts. The STU expects this thrust to go above the prior highs, which is only 4bps higher on the 10-yr, and a bit more on the on the 30-yr (4.84%). This suggests the break could be fast, followed by a reversal. It is noteworthy that the triangle in Treasuries is also seen in other markets, like Shanghai equities and certain currency pairs, such as the AUD/CAD, so this sharp spike & reversal may be mimicked across other markets. More on currencies below.

The next chart shows a heads & shoulders pattern, which would suggest a run up from the neckline as far as the dip below the neckline - or to above 5% in the 10-yr, and 6% in the 30-yr. Head & Shoulders are often seen and seldom fulfilled, so be cautious on this projection.

Yields are NOT rising due to inflation, and hence the real rate is rising as well, which should slow the economy - double dip coming? There are no particular economic woes which should push rates higher. Could the rise be a return to normalcy, with a 3-4% GDP expectation ahead? Perhaps, but that view would not explain why the bad Treasury auctions this week, nor the sudden spike upwards. David Rosenberg notes how a similar rise (90bp) happened from March to June 2007, right before the big credit crunch hit. Have we started that again, in March again? Are we seeing a shot across the bow, a warning shot of the coming second wave of the crisis?

Another explanation is that Bill Gross of PIMCO caused a rotation out of bonds by saying that the three-decade bull market in bonds is over. Real rates are expected to rise, especially after the Fed begins raising short-term rates. PIMCO is now moving into low-deficit sovereign debt (Germany, Canada - but not the US) and stocks. No surprise, the spread between the 10-yr Treasury and the German bonds have widened this week. So if this turns out to be a blip, blame Bill.

Related to this is the continued Greek Tragedy. A deal was announced, or maybe not; but the critical fact is that Germany decided not to bail out Greece. The best analysis of this I have read comes from STRAFOR's Mitteleuropa Redux report. Germany is going to strengthen its position and let the profligate Club Med economies fade. No surprise that the bonds of the PIGS are sinking. Greek problems first spilled over to Portugal, and now Spain. These are all countries whose debt-to-GDP is way too high.

With the Dollar strengthening, why are Treasuries weakening? We need to ask the question of whether ObamaCare is a straw that is breaking the camel's back. Its deficit impact is years away (although tax increases come first), and it is easy political hay to claim it is spooking the markets. Yet the sum of the indicators above is that US Treasuries are beginning to lose their pre-eminence as the lowest risk, best quality place to park money. ZH did an analysis which observed as many others have that "the US is on a collision course with an unmitigated funding disaster" then added "with recently passed healthcare reform, look for the redline indicating total debt to go increasingly exponential". Here is their chart with that red line, showing how fast it has risen over the past 18 months:

Their most interesting insight is the Fed has been pushing the lengthen the maturities of this debt. They can continue to sell short-term bills at essentially zero rates, but want to push buyers into longer maturities. As they do this, they begin to lose control over rates. Simply put, they can keep short term rates low, but the market determines mid- and long-term rates.

Perhaps the market is digesting this revised deficit chart, which was quietly let out on March 5, a few weeks before the ObamaCare passage. It shows the structural deficit is much worse than imagined, and we will hit ZH's collision with funding disaster faster. Now adding ObamaCare and its full-ten-year cost of $2.4T, these numbers would be dramatically worse than even the higher revisions. Of course, it is really difficult to truly assess the impact of ObamaCare, but every program like it since Medicare has come in grossly worse than estimated, not better.

Even without ObamaCare, the CBO estimates the "deficit held by the public", which excludes intra-government holdings like social security, increases from 53% today to over 90% of GDP by 2020, putting us into the PIGS arena. The book by Rogoff and Reinhart, This Time is Different: Eight Centuries of Financial Folly (2009), which looked systematically at these sorts of crises, found that the 90% level was the tipping point to lower growth, making it near impossible to grow out of the debt burden - and hence instead fall into sovereign debt default.

GDP revised down to 5.6 (which I think was below estimates). I wonder what the excuse will be this time? Maybe just to confuse everyone they will say its because the rate was revised up to 5.9 last time! But overall are readers here surprised? Na - didn't think so.

Well, right now we usually see a negative earnings "warning" from companies that need to make such an announcement just before the end of the quarter. Thus far, we have not seen even ONE single earnings warning.

Meanwhile, we have come off of two of the strongest consecutive earnings quarters (according to Thompson Financial)literally in history . . . and are now looking at an $80 number for 2010 S&P earnings. Put a 14 multiple on that and you get 1120. Put a 15 multiple on it and you get 1200.

Right or wrong, that is what portfolio managers are looking forward to . . . and current market prices appear to reflect that.

Garth, good point about GDP to deficit already above 80%. The 90% number is actually "deficit held by the public" which excludes intra-governemnt holdings (ie social security and other trust funds). Right now debt held by the public is only 53%. It is debt held by the public reaching 90% of GDP that should concern us.

From the link in my post comes this explanation:

In their book, This Time Is Different (Eight Centuries of Financial Folly, Princeton University Press, 2009), Carmen Reinhart and Kenneth Rogoff make two critical points:
…If there is one common theme to the vast range of crises we consider in this book it is that excessive debt accumulation, whether it be by the government, banks, corporations, or consumers, often poses greater systemic risk that it seems during a boom……Although private debt certainly plays a key role in many crises, government debt is far more often the unifying problem across the wide range of financial crises we examine…And, the number they peg as being very serious is debt at 90% of GDP. Once debt hits that level, a serious financial crisis is much harder to avoid.